In October 2011, the Swiss legislator published a proposal for the implementation of the global regulatory framework known as Basel III, as applicable for Swiss banks. The proposed implementation of Basel III in Switzerland will be effected mainly through an amendment of the Federal Ordinance on Capital Adequacy and Risk Diversification for Banks and Securities Dealers (CAO) and of various Circulars issued by Finma, the Swiss Financial Market Supervisory Authority.
The new regulatory capital requirements are scheduled to enter into force on January 1 2013, with an implementation period extending to the end of 2018 (with the exception of the introduction of a macro-prudentially-motivated countercyclical capital buffer that may be relevant as of March 1 2012).
The new regulatory capital requirements in the CAO will basically apply to all banks, regardless of their legal form (including cantonal banks and banks in the legal form of cooperatives), although only those in the form of joint-stock companies are discussed here.
Due to the importance of the Swiss financial centre for the Swiss economy as a whole and as a result of the financial crisis of 2007 to 2009, the legislator and Finma proposed seperately from the implementation of Basel III, measures aiming at containment of the main causes of financial difficulties for Swiss banks and at creating more flexibility when dealing with financial institutions in financial difficulties.
As an example, Finma issued a regulation on November 20 2008 stipulating minimum capital requirements for large banks between 50% and 100% above the requirements under the Basel II framework. The regulation also introduced a leverage ratio (ratio of core capital to total assets) of at least 3% on a consolidated basis at a group level, and of at least 4% on a non-consolidated basis for each individual financial institution. These measures are subject to a transition period ending in 2013. The goal was to enhance the resilience of both large Swiss banks (UBS and Credit Suisse), given their systemic importance.
On January 1 2011, the so-called Basel 2.5 framework was introduced by the Basel Committee on Banking Supervision. The amendments were enacted in Switzerland as amendments of the CAO and the related Finma Circulars and included higher capital requirements addressing market risks and risks resulting from securitisations, as well as more stringent valuation rules for the banking book. Of the approximately 300 banks subject to supervision by Finma, the changes affected approximately 40 banks (those using the international, as opposed to the Swiss, approach to risk diversification).
The bank insolvency law was rendered more flexible by the amendment of Art. 28 et seq of the Swiss Federal Act for Banks and Saving Institutions (Banking Act) which came into force on September 1 2011. The revised rules introduced, among other things, new options available in reorganisation proceedings. For example, the transfer of assets and liabilities as well as of contractual relationships to other legal entities (bridge banks) is now possible.
The too-big-to-fail debate led to a proposal to introduce new rules into the Banking Act dealing with banks of systemic importance. This was discussed and approved by the Swiss Parliament in its autumn 2011 session. Whether a bank qualifies as a bank of systemic importance depends on its size, its importance for the financial system as a whole and how easily the services it provides can be provided by other banks.
Under the new legislation, the Swiss National Bank will determine in consultation with Finma whether a bank qualifies as a bank of systemic importance. If it does, the bank is subject to additional regulatory capital requirements, a more stringent liquidity regime and additional organisational requirements.
The regulatory capital requirements applicable to banks of systemic importance go beyond the requirements of Basel III. We outline such additional requirements for banks of systemic impertance in the last section of this article.
Implementation of Basel III in Switzerland
It is proposed that the Basel III framework will be implemented in Switzerland primarily through an amendment of the CAO, as well as through an amendment of various Finma Circulars and the release of new ones. The following Finma Circulars address the implementation of Basel III: (i) Finma-Circular 2008/19: Credit risks – banks; (ii) Finma-Circular 2008/20: Market risks – banks; (iii) Finma-Circular 2008/22: Capital adequacy disclosure – banks; (iv) Finma-Circular 2008/23: Risk diversification – banks; and (v) Finma-Circular 2013/x: Eligible capital – banks, based on Finma-Circular 2008/34: Core capital – banks.
Under the Basel III framework, all Swiss banks organised as stock corporations – not only banks of systemic importance within the meaning of the too-big-to-fail legislation – may make use of the newly-created capital instruments included in the Banking Act as part of too-big-to-fail legislation. These include bonds with a write-off feature, reserve capital, and convertible capital.
The new capital regime aims at achieving a higher resilience of banks to losses compared to the regime under the Basel II framework. This will be achieved by, among other means, ensuring that banks have access to sufficient capital of good quality for absorbing losses in a going concern context. As a result, the numerator of the applicable BIS ratios will be increased. Also, certain changes to the method for determining risk-weighted assets will result in modifications of the denominator of such BIS ratios.
The size of required total capital (without taking into account the equity capital buffer and the countercyclical buffer) has not been changed, and remains at 8% of risk-weighted assets. However, the composition of such capital changes significantly. Banks must now hold Common Equity Tier 1 (CET1) capital of 4.5% of risk-weighted assets (previously 2%). In addition, banks must create a capital buffer in the form of CET1 capital of 2.5% of risk-weighted assets, which leads to a total CET1 capital of 7% of risk-weighted assets. A possible additional requirement is a macro-prudentially motivated countercyclical capital buffer of up to 2.5% of risk-weighted assets, also consisting entirely of CET1 capital.
The revised framework also includes a leverage ratio and an internationally-harmonised global liquidity coverage ratio, both aiming at reducing risks of the existence of excessive leverage in the banking system.
Adding a Swiss finish
The requirements of the Basel III framework are supplemented by additional capital requirements introduced as a so-called Swiss finish by Finma Circular 2011/02 (Additional Swiss Requirements). The regulation set out in the Circular entered into force on July 1 2011 and will remain applicable also post-implementation of Basel III.
In the circular, Finma divides banks into four categories, according to (i) total assets; (ii) assets under management; (iii) privileged deposits; and (iv) required equity capital. The additional capital requirements of the Swiss finish are only applicable for categories (i) to (iv); banks in category (v) must only fulfil the requirements of the Basel framework. Approximately two-thirds of Swiss banks belong to the fifth category. Banks of systemic importance are, according to the too-big-to-fail legislation, subject to separate capital requirements exceeding those of Finma Circular 2011/02.
Under certain credit market circumstances, a countercyclical buffer of up to 2.5% of additional CET1 capital may temporarily apply to all categories of banks, where required for macro-prudential reasons. This countercyclical buffer aims at improving the resilience of the banking sector during phases of excessive credit growth.
Components of regulatory capital
The current version of the Swiss CAO (pre-implementation of Basel III) includes three types of eligible regulatory capital (Tier 1, Tier 2 and Tier 3). Tier 1 capital is sub-divided into actual core capital and innovative core capital. Tier 2 capital is sub-divided into upper Tier 2 and lower Tier 2 capital. Tier 3 capital includes other forms of qualifying additional capital.
The new legislation according to the draft-CAO (implementing Basel III) aims at both improving the quality of components of regulatory capital and reducing the sub-divisions that were made in the legislation so far. In addition to CET1 capital, the draft-CAO recognises only additional core capital (Additional Tier 1, or AT1) as Tier 1 capital and some forms of additional capital as Tier 2 capital.
CET1 capital: pursuant to Art. 19 et seq. of the draft-CAO (and as already required by the Basel II framework), CET1 capital includes actually paid-in capital, disclosed reserves, provisions for general banking risks, earnings carried forward and current earnings after deduction of the expected proportion of CET1 capital to be distributed. In order to qualify as CET1 capital, share capital must not include preferential rights (in a liquidation scenario, for example). Therefore, any share capital in the form of preferred shares or preferred non-voting shares would not be eligible as CET1 capital.
Additional Tier 1 capital: such capital can be issued in the form of an equity or debt instrument. Pursuant to Art. 17 of the draft-CAO, AT1 must be completely paid in or created internally, may not be financed through loans granted by the bank, and must neither be subject to a set-off with claims of the bank nor be secured by the bank. Furthermore, pursuant to Art. 24 of the draft-CAO, such capital may neither have a fixed term nor may it be issued with an expectation that it will be repaid early.
Such additional Tier 1 capital may be repaid after five years at the earliest, and only at the bank's initiative and with the consent of Finma. Dividends or other income may only be paid in respect of such capital if earnings or reserves are available, provided that it must be at the bank's discretion whether any such payments are made. In addition, payments to investors may neither be linked to the creditworthiness of the bank nor subject to a step-up mechanism. Additional Tier 1 capital also must not have any feature that could hinder a rights offering made by the bank.
According to Art. 24 (1)(f) of the draft-CAO, if the CET1 capital has fallen below a level of 5.125% of the total capital or, if reached earlier, upon the occurrence of any other pre-determined trigger event, Finma may require that AT1 capital in the form of a debt instrument (excluding AT1 capital in the form of preferred shares or preferred non-voting shares) be converted to CET1 or that a write-off be triggered for such debt in an amount as required to be in compliance with the required regulatory capital ratios. Such loss absorption must be provided for in the terms and conditions of the AT1 instruments.
Tier 2 capital: Pursuant to Art. 27 of the draft-CAO, Tier 2 capital must meet the general requirements applicable to equity capital pursuant to Art. 17 of the draft-CAO that also apply to Tier 1 capital (be completely paid-in or created internally, not be financed by loans granted by the bank, not be subject to a set-off with claims of the bank or be secured by the bank). Such Tier 2 capital must have an initial maturity of at least five years and may not be subject to incentives for the bank to repay the Tier 2 capital. As with AT1 capital, Tier 2 capital may only be repaid after five years at the earliest, and only at the bank's initiative and with the consent of Finma. Any step-up mechanism increasing the amounts due to investors before maturity is not allowed.
Under the current regime (pre-implementation of Basel III), hybrid instruments issued by banks are subordinated to the claims of the other bank creditors in the case of a liquidation, bankruptcy, or restructuring of a bank. However, measures available before such situations, such as a waiver of interest payments by the bank or any deferral of interest and capital payments, failed in reality. This was justified with market expectations, as was the often swift repayment of hybrid capital.
Under the revised regulatory capital regime, the concept of subordination is replaced by a concept of loss absorption. The new regime differentiates between loss absorption under the aspect of continuation of bank operations (going concern) and loss absorption at a point in time when insolvency is imminent (gone concern).
In a going concern scenario, AT1 capital in the form of debt must take its share of losses upon the occurrence of a pre-determined trigger event: at the latest, however, when the level of the CET1 capital has fallen below a threshold of 5.125% of the total capital. Such loss absorption must take place either through a write-off or a conversion into CET1.
In a gone concern scenerio, meanwhile, sharing losses when insolvency is imminent (point of non-viability, or PONV) is regulated by Article 26 of the draft-CAO. Imminent insolvency means that the bank will likely be able to survive if the PONV consequences are triggered. It is, therefore, not necessary that the bank becomes subject to restructuring proceedings. Having said that, it will probably be difficult clearly to distinguish cases of impending insolvency, where the PONV consequences according to Art. 26 of the draft-CAO are triggered, from cases of restructuring proceedings, where some business activities may be continued and possibly transferred to a bridge bank pursuant to Art. 29 et seq. of the Banking Act.
The loss absorption mechanisms are the same as those for a going concern, namely a write-off or the conversion into CET1. While the loss absorption rules in a going concern scenario only apply to AT1 capital in the form of debt, such loss absorption rules in a gone concern scenario apply to AT1 capital in the form of debt and equity and to Tier 2 capital. The loss absorption mechanisms must be included in the terms and conditions of the debt instrument or the articles of association, respectively, and be approved by Finma.
Loss absorption is triggered at the latest before accepting government aid, or if Finma considers it necessary. Finma is given more room for discretion in initiating loss absorption in a gone concern than in a going concern. This makes sense in the wider context of Finma's authority to initiate reorganisation proceedings, given that triggering PONV measures comes very close to initiating such restructuring proceedings.
Enhancement of the capital basis
In the context of the too-big-to-fail debate, the Swiss Parliament approved in its autumn 2011 session provisions applicable to banks of systemic importance. In addition, provisions regarding the creation of new capital instruments, which are available for all banks (not only banks of systemic importance) were adopted. Such new capital instruments include bonds with a write-off feature, reserve capital and convertible capital.
Write-off bonds: the new provisions of the Banking Act regarding such bonds were formulated very sparingly and constitute in essence the basis for a possible recognition as regulatory capital. Bonds with a write-off feature may be used for loss absorption in both going or gone concerns. The terms and conditions of the bonds must describe the trigger mechanism, which must be approved of by Finma. Article 115 of the Swiss Code of Obligations is relevant for the write-off feature, allowing an agreement on a partial or entire waiver of debt.
Reserve capital: it serves the purpose of enabling the bank to raise new capital. It is not a capital instrument that may be used to absorb existing losses in the context of the loss absorption mechanics discussed above.
The new provisions on reserve capital only apply to banks and not to other stock corporations. However, reserve capital operates similarly to registered capital that may be issued by any joint-stock corporation. In the same way as registered capital, reserve capital is created by a resolution of the shareholders meeting amending the articles of association, thereby enabling the board of directors of a bank to raise capital quickly when necessary. In order to grant to the board of directors as much flexibility as possible, the provisions on reserve capital allow the issuance of new shares at a discount to the market price, provided that this is in the interest of the bank with respect to a swift and complete placement of the new shares.
While registered capital is available for only two years and is limited in terms of size to 50% of the issued capital, those limitations do not apply to reserve capital of banks. Reserve capital may not be paid up with the bank's own funds.
Convertible capital: such capital as specified in the new provisions of the Banking Act may appear similar to conditional capital that may be issued by any joint-stock corporation. There are substantial differences to be highlighted, however.
The issuance of convertible capital must be based on a resolution passed by a shareholders' meeting amending the articles of association. Such resolution gives to the board of directors the power to decide when and how to issue such convertible capital. As opposed to conditional capital, the conversion of convertible capital into shares or non-voting shares is not instigated by the investor, but is triggered by an event determined beforehand. Such convertible capital may be used for purposes of loss absorption with respect to both going and gone concerns. The terms and conditions of the bonds must describe the trigger mechanism and the issuance must be approved by Finma.
If a trigger event occurs, the board of directors must carry out the conversion into shares or non-voting shares by means of a publicly-notarised resolution. The capital increase must then be entered into the commercial register without delay.
Eligibility of capital instruments under the new regime
As regards the availability of the new capital instruments described above for the different forms of regulatory capital, the following applies:
CET1 capital pursuant to Art. 19 et seq. of the draft-CAO: Common shares and non-voting shares (participation certificates) qualify as CET1 capital. However, preferred shares and preferred non-voting shares are not recognised as CET1, as long as the preferred status results in a privileged access to liquidation proceeds and/or dividends or other distributions of capital.
AT1 capital pursuant to Art. 24 et seq. of the draft-CAO: Additional Tier 1 capital includes preferred shares and preferred non-voting shares, both of which lose their preferred status upon the occurrence of a PONV (point of non-viability). Such PONV consequences must be dealt with in the bank's articles of association. Other components qualifying as AT1 capital includes debt without a fixed term that provides for loss absorption in both going concern (5.125% trigger) and gone concern PONV situations by means of conversion into CET1 or a write-off.
Tier 2 capital pursuant to Art. 27 of the draft-CAO: Tier 2 capital includes debt with a minimum five-year maturity providing for loss absorption in "gone concern" situations (occurrence of PONV) either through conversion into CET1 capital or a write-off.
Between January 1 2013, which is the scheduled date of entry into force of the new regulatory capital requirements, and December 31 2022, certain capital instruments complying with the pre-Basel III regime and instruments complying with the post-Basel III regime may both be used. According to Art. 125d of the draft-CAO, the categories are: (i) CET1 capital pursuant to the draft-CAO; (ii) AT1 Capital pursuant to the draft-CAO; (iii) Tier 1 Capital pursuant to the CAO; (iv) Tier 2 Capital pursuant to the draft-CAO; and (v) Tier 2 Capital pursuant to the CAO.
Tier 1 Capital issued under the pre-Basel III regime that will not be recognised under the draft-CAO as CET1 or AT1 capital is eligible pursuant to Art. 125d of the draft-CAO, provided that its recognition is reduced at a declining rate of 10% per year over a maximum period of 10 years and that it was issued before September 12 2010 (Basel III was fundamentally adopted on this date, at which point the banks were informed of the new provisions).
With respect to AT1 or Tier 2 Capital issued under the pre-Basel III regime that is not in compliance with the new provisions of the draft-CAO, its eligibility as regulatory capital depends on the date the instrument was issued. If the instrument was issued after September 12 2010, it is no longer eligible. If the issue date falls between September 12 2010 and December 31 2011, the instrument may be recognised if only the PONV-feature according to Art. 26 of the draft-CAO is missing.
In such event, however, the recognition of the instrument is reduced at a declining rate of 10% per year over a maximum period of 10 years. If the issue took place before 12 September 2010, the recognition of the instrument is reduced at a declining rate of 10% per annum over a period of a maximum of 10 years.
Tier 3 Capital pursuant to the pre-Basel III regime under the CAO is not eligible as of the entering into force of the new regulatory capital requirements.
Additional requirements for banks of systemic importance
For banks of systemic importance, on December 5 2011, regulatory capital requirements exceeding those for other banks were released as draft secondary legislation to the Banking Act. Banks of systemic importance are required to hold CET1 capital of 4.5% of risk-weighted assets (as other banks) and an additional equity capital buffer of 8.5% of risk-weighted assets. If the equity capital to be held as an equity capital buffer falls temporarily below the threshold, the bank must demonstrate what measures it will take, and when it will take them, in order to re-establish the required regulatory capital.
The equity capital buffer may consist of CET1 capital, or, up to 3% of risk-weighted assets, of convertible capital with a conversion or write-off trigger at 7% of eligible CET1 capital (of the total capital). It is important to ensure that, before conversion, convertible capital meets the requirements applicable to Tier 2 Capital of banks that are not of systemic importance. This means, in particular, that a loss absorption at the point of non-viability pursuant to Art. 26 (1), (2) of the draft-CAO must be applicable.
In addition, as a so-called progressive component, banks of systemic importance must hold additional equity capital in an amount to be determined by Finma at the end of the second quarter each year for the individual bank or the financial group concerned. The amount of this progressive component will depend on various factors such as the possibility of restructuring or liquidation of the bank, and must be at least 1%. It may consist of convertible capital with a conversion or write-off trigger at 5% of eligible CET1. It is important to keep in mind that convertible capital, before conversion, must fulfil at least the same conditions as Tier 2 Capital for banks that are not of systemic importance (including loss absorption at the point of non-viability pursuant to Art. 26 (1), (2) of the draft-CAO).
Moreover, banks of systemic importance, as all other banks, will be required to hold CET1 capital of up to 2.5% if a macro-prudentially motivated countercyclical equity capital buffer will be introduced.
||Martin Lanz |
Martin Lanz is the head of the firm's banking and finance team in Zurich. He advises banks and other financial institutions, as well as borrowers and issuers of debt and equity, in regulatory matters and in domestic and cross-border transactions, such as bond and note issues, syndicated loans, convertibles, rights offerings, IPOs, tender offers, collective investment schemes, structured products and derivatives, as well as the structuring of employee stock option plans. He previously worked in the legal and documentation department of the capital markets division of Swiss Bank Corporation (now UBS), and at an international law firm in New York. He joined Schellenberg Wittmer in 1991 and became a partner in 1995. Martin was admitted to the Swiss Bar in 1983 and graduated as a Doctor of Law from the University of Basle in 1985.
||Olivier Favre |
Olivier Favre is a member of the firm’s banking and finance team in Zurich. He advises clients on all aspects of banking and finance law, including derivatives and structured finance transactions. Olivier also advises clients on any aspects of the regulation of Swiss banks, broker-dealers, insurance companies, asset managers and collective investment schemes. Before joining Schellenberg Wittmer, Olivier was a legal counsel at Goldman Sachs International (2007 to 2009) and an associate at Allen & Overy (2004 to 2007) in London, where he specialised in OTC derivatives, structured finance transactions and fund products. Olivier studied law at the University of Zurich (Dr iur) and at Harvard Law School (LLM) and was admitted to practise in Switzerland in 2000.